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Mediocre Growth, High Risks, and The Long Road Ahead

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For the past six months, the world economy has been on what is best described as a roller coaster.

Last autumn, a simmering European crisis became acute, threatening another Lehman-size event, and the end of the recovery.  Strong policy measures were taken, new governments came to power in Italy and Spain, the European Union adopted a tough fiscal pact, and the European central bank injected badly needed liquidity.   Things have quieted down since, but an uneasy calm remains.  At any moment, it seems, things could get bad again.

This shapes our forecasts.  Our baseline forecast, released by the IMF on April 17,  is for low growth in advanced countries, especially in Europe.  But downside risks are very much present.

Brakes hampering growth

This baseline is constructed on the assumption that another European flare-up will be avoided, but that uncertainty will linger on.   It recognizes that, even in this case, there are still strong brakes to growth in advanced countries:  Fiscal consolidation is needed and is proceeding, but is weighing on growth.  Bank deleveraging is also needed, but is leading, especially in Europe, to tight credit.  In many countries, in particular in the United States, some households are burdened with high debt, leading to lower consumption. Foreclosures are weighing on housing prices, and on housing investment.

These brakes to growth are reflected in our projections.  For advanced countries as a whole, we forecast growth of 1.4 percent in 2012, and 2.0 percent in 2013.   For the United States, the numbers are 2.1 percent and 2.4 percent.   For the euro area, the numbers are -0.3 percent and 0.9 percent.   The negative number for 2012 reflects negative growth in countries such as Italy and Spain; we forecast German and French growth to be positive, although quite low.

Turning to emerging and developing economies:   Our forecasts are for continued strong growth, although somewhat lower than in the past.  For many countries, the immediate challenges come mainly from outside, in the form of lower exports to advanced countries, volatility of commodity prices, and high volatility of capital flows.


The forecasts reflect our belief that most emerging and developing economies will be able to handle these challenges, by using the monetary and fiscal space they still have, and by using appropriate macro prudential measures to deal with the volatility of capital flows or high domestic credit growth.   Our forecasts for 2012 are for 8.2% for China, 6.9% for India, 3.0% for Brazil, roughly the same as in January, and slightly higher for Russia at 4.0%.    For sub-Saharan Africa, our forecast is for continuing strong growth, at 5.4%.

Putting things together, these forecasts imply a forecast for world growth of 3.5% for 2012, improving to 4.1% for 2013.   This is roughly 0.2% higher than our January forecast, but 0.5% lower than our forecast last September.

So, what are the risks?

Geopolitical tension affecting the oil market is surely a risk. The main risk remains, however, that of another acute crisis in Europe. The building of the “firewalls”, when it is completed, will represent major progress. By themselves, however, firewalls cannot solve the difficult fiscal, competitiveness, and growth issues that some of these countries face. Bad news on the macroeconomic or the political front still carries the risk of triggering the type of dynamics we saw last fall.

On the policy front:

Many of the policy debates center around how best to balance the adverse short-run effects of fiscal consolidation and bank deleveraging versus their favorable effects in the long run.

In the case of fiscal policy, the issue is complicated by the pressure from markets for immediate fiscal consolidation. It is further complicated by the fact that markets appear somewhat schizophrenic, asking for fiscal consolidation, but reacting adversely when consolidation leads to lower growth.

The right strategy remains the same as before: While some immediate adjustment is needed for credibility, the search should be for credible long-term commitments, by passing measures that decrease trend spending, and by putting in place fiscal rules that reduce deficits over time. Insufficient progress has been made along these lines, especially in the United States and in Japan.

In the case of bank deleveraging, the challenge is to make sure that deleveraging does not lead to a credit crunch, either at home, or abroad. Partial public recapitalization of banks should remain on the agenda. To the extent that it would increase credit and activity, it could easily pay for itself, more so than most other fiscal measures.

Turning to policies aimed at reducing risks, the focus is clearly on Europe.  The measures taken in response to the fall crisis represent important progress.  Further measures must however be taken to decrease the links between sovereigns and banks, from common deposit insurance, to common regulation and supervision.  Now that the fiscal pact has been introduced, Euro countries should also explore the scope for issuing common sovereign bonds.

Finally, taking one step back, perhaps the highest priority, but also the most difficult to achieve, is to durably increase growth and decrease unemployment in advanced economies, and especially in Europe. Low growth not only makes for a subdued baseline forecast, but also for a harder fiscal adjustment, and higher risks along the way. A search for structural and fiscal reforms that help in the long run, but do not depress demand in the short run should be very high on the policy agenda.

Such reforms probably hold the key to a successful and durable exit from the crisis.